Keeping up with terms and developments in crypto is tough. When you think you're at pace, new terms sprout like mushrooms, making you feel outdated. DeFi Yield Farming is one such term.

You may have heard that it's one of the best ways to put your money to work in crypto. That's right. Yield farming is a major contributor to the 6900% growth of the total value of assets locked in DeFi since 2020. And that is why people call it the lifeblood of DeFi platforms.

There's a high chance you're wondering what DeFi yield farming means, how it works, and if it has any risks. Take a deep breath. You don't have to wonder anymore. I'll help you with those. In this article, you'll learn:

What yield farming is
What you need to get started
How it works
The associated risks, among others.

What is yield farming?

Yield farming is a way to earn passive income for your cryptos. That is, lending out cryptos you're not using to earn an interest.

It's similar to lending someone money for running a business. During payback, the person pays both the capital and interest.

But in the case of DeFi yield farming, you supply the crypto to a DeFi service provider (protocol) to enable it to provide services such as:

Lending crypto to borrowers
Staking cryptos to secure a blockchain network like in Ethereum
Providing liquidity in a decentralised exchange to enable crypto swaps.

As a yield farmer, you render a service and get rewarded. It ends as a win-win for you, the protocol you're helping out, and the users of the protocol.

Popular yield farming strategies

Compound Finance made yield farming popular in 2020. Since then, yield farmers have come up with different ways to earn yields. Here are the top 3 strategies you can apply to earn the best yields:

1. Lending

When you lend to earn yield, you supply cryptos to a DeFi protocol to earn a reward. Let's assume you have 1000 DAI in your wallet doing nothing. You could lend it to a protocol like Aave for a specific time and earn rewards.

But how does Aave, in this case, get the reward it offers you?

Aave is a lending protocol that lends crypto to borrowers. But here's the thing: Aave has no cryptos to lend out. It relies on community members to raise cryptos.

When you supply 1000 DAI to Aave, someone borrows it at an interest rate Aave establishes. When the borrower returns the money and the interest to Aave, Aave returns your capital. Aave also shares the interest with you.

A protocol such as Curve Finance also rewards its users with the native token, CRV, during lending. That is called liquidity mining. The protocol does this to attract more users. And you can easily convert your reward to cash on crypto exchanges.

Other examples of lending protocols include:

2. Liquidity provision

Liquidity provision means supplying two cryptos in equal amounts to a liquidity pool. When you supply cryptos to such liquidity pools, you enable other users to swap cryptos.

For example, you can supply $100 worth of ETH and USDT each to an ETH/USDT liquidity pool on Uniswap. Therefore, anyone who wants to swap their crypto in such a pool will do that courtesy of your help. The protocol, in this case Uniswap, charges those users a fee for the swap.

In return for the help you rendered Uniswap, Uniswap shares the swap fees with you at percentages.

But why can't Uniswap provide the funds, do the swaps, and take all the profits?

Uniswap is a decentralised exchange. That is a fancy word to say that it is designed to depend on community members to supply cryptos for it to function.

Other examples of decentralised exchange to farm liquidity include:

3. Staking cryptocurrencies

Staking means locking away crypto for a specified time to earn rewards. The locked crypto helps secure a blockchain network, like Ethereum.

Staking is like locking away funds in a fixed deposit account. The bank uses the money during that period and pays you some interest at an agreed time.

Here are examples of staking platforms:

Requirement for yield farming

Here are a few things you'll need to start yield farming:

Cryptocurrency: In yield farming, you provide a service with your crypto to earn some extra crypto. You can start with any amount, but the bigger your crypto capital, the bigger your reward. Apart from supplying crypto as capital, you need it to pay your transaction fees.

Wallet: A crypto wallet is like a bank account. Without one, you can't transact or provide a yield farming service. Metamask is an example of a yield-farming wallet.

Platforms and yield farming knowledge: Understanding the platform you want to farm on helps protect your capital. I'll introduce you to some of the top-yield farming platforms in a bit. Apart from knowing the platforms, you should know about yield farming. And that's what this article provides.

Risk management plan: You may get emotional while yield farming. For example, greed may creep in on you. So, it's wise to have a plan for managing risks. Define platforms to use, amount to risk as capital, maximum yield to pursue, how long to farm, when to pull out, and which assets to use, among others.

Time and patience: When it comes to crypto investments, most people are impatient. They want quick results. But it doesn't work that way. Although there could be a high return on yield farming investments, you should give it time to earn this yield.

Top yield farming platforms

Based on the total value of assets locked on DeFi protocols as of November 2023, below are the top five yield farming platforms. I arranged them in descending order. Lido has the highest total value of assets locked.

1. Lido Finance

Lido is a staking platform that enables users to stake crypto to earn rewards. It supports five blockchains such as Ethereum, Polygon, and Solana. The total value of assets locked in Lido, as of November 2023, is $17B.

Yield farmers in Lido earn yields by staking cryptos to secure blockchains. The protocol rewards them with part of the fees users of such blockchain pay.

Lido collects an estimated annualised fee of $607M from its users.

2. Maker Protocol

Maker is a lending protocol and is among the pioneers of lending in DeFi. It runs on the Ethereum blockchain and has an estimated $8B in assets locked in.

Yield farmers in Maker earn profit through fees and interests paid by borrowers using the protocol. As of the time of writing this, Maker earns an estimated annualised fee of $191M from its activities.

3. JustLend

JustLend is a lending protocol that supports tokens of Tron chain origin alone. As of November 2023, JustLend has a total of $5.6B worth of crypto assets locked in its protocol.

Like Maker, yield farmers in JustLend earn yields from lending fees and interests the protocol charges borrowers.

4. Aave

Aave is a lending protocol with a total value of assets worth $5.6B. It supports tokens from over nine blockchains such as Ethereum and Polygon.

Yield framers on Aave make money from lending fees and interests the protocol charges borrowers.

Aave has an estimated $125M in annualised fees collected from users.

5. Uniswap

Uniswap is a decentralised crypto exchange that enables users to swap cryptos. It supports about ten blockchains like Ethereum, BNB chain, and Polygon. The total value of assets locked in Uniswap as of today, November 2023, is worth $3.4B.

Yield farmers in Uniswap earn yields by providing liquidity to liquidity pools. The protocol rewards them with part of the fees users pay. Uniswap collects an estimated annual fee of $460M from its users.

How does yield farming work?

Yield farming works similarly to investments in traditional finance. A business owner needs money to finance a business venture, and you offer it up to them. They use the money to run their business, make profits, and pay back a percentage of the profit as interest.

In yield farming, the business owners are the yield farming platforms. They run their business with contributions from community members. To support, you fund your wallet with some desired crypto and connect to their platform. Then, indicate the service you want to help with by supplying your crypto capital.

After you've supplied the cryptos, the platform uses it to enable services like lending, borrowing, and swapping. As they do that, they charge fees and interest from users and make profits.

The platform cuts you a share of these fees and interests as a reward for helping. Depending on your plan, you may sell and hold onto the interest.

Is yield farming profitable?

DeFi protocols calculate yield farming profits in Annual Percentage Yield (APY) and Annual Percentage Rate (APR).

The difference between APR and APY is that APY uses a compounding formula in calculating yield, while APR doesn't. Here's a deep dive into APY and APR.

The profitability of yield farming depends on a lot of factors such as:

Yield farming duration: How long you offer up your crypto for yield farming affects the size of your earnings. The longer the better.

Gas fees: Gas fees are transaction fees paid to individuals who process transactions on a blockchain network. The higher you pay in transaction fees, the lesser the profits you earn.

Risks: There are some risks associated with yield farming. We'll discuss them in a bit. The more prone a DeFi platform you're using to these risks, the higher the probability that you'll lose money, hence making less profit.

Market conditions: The crypto market appreciates and depreciates over time. The market condition when you reap your yield affects how much profit you make. For example, if you provide liquidity in a bear market and reap the yield in a bull market, you may make a profit.

APY/APR: Every yield farming initiative you want to key into has a specific estimated APY/APR attached to it. You'll find it on the yield farming platform. The higher the APY the more profit you stand to make.

Token supplies and incentives: Sometimes during yield farming, you get rewarded with tokens such as in Curve Finance. Tokens with a limited supply tend to be more valuable than those with an infinite supply. The more tokens with limited supply you earn the higher the profits you'll make.

Diversification: Yield farming is a form of investment. And investment advisors always advise for diversification. When you diversify in yield farming, you commit your money to different crypto classes and various platforms. That way, you minimise risk and stand a high chance of profiting from various areas.

Below is a screenshot from a liquidity pool and vault APY tracking website. It shows the current top APYs for stablecoins in liquidity pools. That will give some numbers to work with.

You can also use the website to extract more information on various APYs.

Yield farming risks

Various risks in DeFi may affect the amount of profits you make while yield-farming. They include:

1. Market volatility

Crypto market volatility is the rapid change in prices of cryptocurrencies in a short time. For instance, Bitcoin can lose a thousand dollars in minutes.

When you earn yield in volatile cryptos like ETH and CRV, you may see it drop in value before you convert it to cash.

To avoid the effect of market volatility, yield-farm with stablecoins such as DAI and USDC. But of course, you'll earn lower yields due to a lower risk

2. Smart contract risks

A smart contract is computer instructions developers put on the blockchain. It runs by itself without external help. Smart contracts execute the services of DeFi platforms like lending and borrowing.

Smart contracts are still in the early years, so they may malfunction due to errors during coding. Bad actors take advantage of this weakness to steal cryptos from users of such smart contracts. It may be difficult to stop them or recover the cryptos when stolen.

For example, investors lost over $7.4M during a smart contract exploit of the Hundred Finance Protocol in April 2023.

Always ensure that the protocols you interact with have been audited. And by reputable auditing companies like Certik and OpenZeppelin.

3. Impermanent loss

Impermanent loss occurs when you deposit cryptos into a liquidity pool to enable other protocol users to swap their cryptos.

It leads to a drop in the value of the assets you deposited compared to when you deposited them.

To avoid impermanent loss, provide liquidity with cryptos of low volatility such as stablecoins like DAI and USDC.

4. Rug pulls

Imagine that you're standing on a rug, and someone pulls it. You'll crash to the ground. In a crypto rug pull, a fraudulent crypto project founder drains all the crypto in the project's smart contract and leaves the investors empty.

When this happens, you lose all your investments. For example, in 2022, some investors lost over $3.3M to the SQUID rug pull.

The best way to avoid rug pulls is to research the reputation of the founders and top participants of the project.

5. Liquidation risks

Liquidation happens when a smart contract in a lending protocol like Aave takes away your collateral to pay the debt you owe.

Due to the rapid movement of cryptos, the value of your collateral could depreciate below the required value. Once this happens, the smart contract gets a notification to take away the collateral. That way, the protocol doesn't incur a loss to itself.

To avoid liquidation after borrowing, you should constantly check your borrowing account. When your collateral depreciates, you must top it up with more collateral.

6. High gas fees

A gas fee is the money you pay network transaction processors for the work they help you do. When you lend, borrow, swap, or send cryptos, someone is at the other end to ensure your transaction.

Sometimes, when there are a lot of people using a service, the gas fee may go high. That means you get charged in excess.

When gas fees are high, you should wait for them to reduce before initiating your transactions.

Yield farming FAQs

What is the difference between farming and liquidity mining?

Liquidity mining is one of the strategies used by yield farmers to earn high yields. There are other strategies such as staking, lending, and borrowing. In liquidity mining, yield farmers supply cryptos to yield farming platforms to earn native tokens as rewards. For example, when you supply liquidity to Curve Finance, you earn CRV tokens as an extra incentive in addition to the interest (APY).

What is yield farming vs staking?

Staking is one of the strategies used by yield farmers to earn high yields. There are other strategies such as liquidity mining, lending, and borrowing. In staking, you supply crypto to secure a blockchain such as Ethereum from attacks by manipulators. And you earn a reward for it.

How do I start yield farming?

To start yield farming, create a wallet on Metamask or any other wallet-yiproviding service. Fund the wallet with the crypto of choice and connect to platforms like Uniswap, Aave, Lido, Maker, and JustLend, among others. Provide liquidity, stake, or lend your crypto to earn yields.

The bottom line

Yield farming is a new way of making passive income in crypto. But to maximise this new opportunity, you must first understand it, how it works, and the risks involved. Otherwise, you could lose your hard-earned money.